Asset Pricing Restrictions on Predictability: Frictions Matter

Management Science, Vol. 58, No. 10, pp. 1916-1932, 2012

32 Pages Posted: 4 Mar 2005 Last revised: 10 May 2014

See all articles by Frans de Roon

Frans de Roon

Tilburg University - Department of Finance

Marta Szymanowska

Erasmus University Rotterdam (EUR) - Department of Finance; Erasmus Research Institute of Management (ERIM)

Date Written: November 11, 2011

Abstract

U.S. stock portfolios sorted on size, momentum, transaction costs, M/B, I/A and ROA ratios, and industry classification show considerable levels and variation of return predictability, inconsistent with asset pricing models. This means that a predictable risk premium is not equal to compensation for systematic risk as implied by asset pricing theory (Kirby 1998). We show that introducing market frictions relaxes these asset pricing moments from a strict equality to a range. Empirically, it is not short sales constraints but transaction costs (below 35 basis points) that help to reconcile the observed predictability with the Fama-French-Carhart four-factor model and the Chen-Novy-Marx-Zhang three factor model, and partly with the Durable Consumption model. Across the sorts, predictability in industry returns can be reconciled with all models considered with only 25 basis points transaction costs, whereas for momentum and ROA portfolios up to 115 basis points are needed.

Keywords: time-series predictability, cross-sectional predictability, asset pricing tests, market frictions

JEL Classification: G12, G17

Suggested Citation

de Roon, Frans A. and Szymanowska, Marta, Asset Pricing Restrictions on Predictability: Frictions Matter (November 11, 2011). Management Science, Vol. 58, No. 10, pp. 1916-1932, 2012. Available at SSRN: https://ssrn.com/abstract=676025 or http://dx.doi.org/10.2139/ssrn.676025

Frans A. De Roon

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 1 3466 8361/3025 (Phone)
+31 1 3466 2875 (Fax)

Marta Szymanowska (Contact Author)

Erasmus University Rotterdam (EUR) - Department of Finance ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands
+31104089607 (Phone)

HOME PAGE: http://www.rsm.nl/mszymanowska

Erasmus Research Institute of Management (ERIM) ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands

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